Quantitative & Strategy Cam Hui, CFA June 13, 2017 cam@[email protected] SHOPIFY INC. THE CHANGES TO THE 2018 FED THAT NO ONE IS TALKING ABOUT Highlights As the market looks ahead to the upcoming FOMC meeting, it's time to consider not just what the Fed might do at its June meeting, but for the remainder of the year. The bigger question is how the Fed reaction function might change in 2018 as the new Trump nominees to the Board of Governors assume their posts. Another question to consider is whether the Trump Administration intends to keep Janet Yellen as Fed Chair. As there are three open positions on the board, and three rumoured nominees, any potential new Fed Chair would come from the current list of new appointees. Of the three, the most likely candidate is Marvin Goodfriend. Current readings indicate that while U.S. economic conditions may appear to be a bit soft, the global outlook is strong. The Fed should continue on its path of monetary policy normalization, which translates into three rate hikes this year and the initiation of balance sheet reduction in either late 2017 or early 2018. However, should all three potential candidates be nominated and appointed to the Fed's Board of Governors, the direction of monetary policy will change quite dramatically, possibly as soon as Q4/17. At a minimum, the Fed is likely to become more hawkish and possibly downgrade the full employment part of its dual mandate. The biggest risk under a Goodfriend Fed is the economy will experience more frequent and deeper recessions, much like the way it did during the 19th Century. In short, while the longer-term outlook for the Fed’s monetary policy direction is uncertain and fraught with risk, it is too early to panic. We prefer to wait for some signs of confirmation of policy changes when these potential candidates are actually nominated before reacting. For now, the current positive fundamental backdrop indicates that the intermediate-term trend for stocks is still up, and pullbacks should be relatively shallow. June 13, 2017 Quantitative & Strategy Fed Preview: What Happens in 2018? As the market looks to the upcoming FOMC meeting, it's time to consider not just what the Fed might do at its June meeting, but for the remainder of the year. The bigger question is how the Fed reaction function might change in 2018 as the new Trump nominees to the Board of Governors assume their posts. Another question to consider is whether the Trump Administration intends to keep Janet Yellen as Fed Chair. As there are three open positions on the board, and there are three rumoured nominees, any potential new Fed Chair would come from the current list of new appointees. Of the three, the most likely candidate would be Marvin Goodfriend. Current market expectations show December 2017 Fed Funds (black line) to be relatively steady, but December 2018 Fed Funds (red line) have been declining. Regardless of whether Goodfriend becomes the new Fed Chair, we examine how the influence of the three likely appointees may change the path of monetary policy in 2018 and beyond. Exhibit 1: A Flattening 2/10 Treasury Yield Curve Source: Datastream Cam Hui, CFA | (604) 724-8404 Page 2 June 13, 2017 Quantitative & Strategy The Fed’s Current Analytical Framework Let's start with the analytical framework of the current Fed. There has been much hand wringing about the decline in inflation. However, it's measured, whether using the Fed's preferred metric of core PCE inflation, trimmed-mean PCE or sticky price inflation, inflation is falling. Exhibit 2: Inflation Is Falling Source: FRED, Federal Reserve Bank of St. Louis For now, evidence of falling inflation is likely to be ignored. As Fed watcher Tim Duy pointed out: The Fed's focus remains on the labor market. Hence, they remain focused on two rate hikes and balance sheet action still to come this year. Here is how the employment picture looks like right now. Unemployment (black line) has fallen to the historically low level of 4.3%, while median nominal real earnings (blue line, quarterly data) has been accelerating, and the more timely average hourly earnings (red line, monthly data) has softened. Cam Hui, CFA | (604) 724-8404 Page 3 June 13, 2017 Quantitative & Strategy Exhibit 3: A Mixed Picture from Unemployment and Wage Growth Source: FRED, Federal Reserve Bank of St. Louis As the Fed has traditionally been cautious, and believed that monetary policy operates with a lag, the natural tendency would be to hike the rate in June and wait for more data. Transitory Weakness? Moreover, the Fed is likely to interpret the current patch of soft economic conditions as "transitory". Sure, the Citigroup Economic Surprise Index has been falling, indicating that macro releases have mostly missed market expectations. Exhibit 4: U.S. Macro Data Has Disappointed Source: Datastream Cam Hui, CFA | (604) 724-8404 Page 4 June 13, 2017 Quantitative & Strategy Looking around the world, however, the global economy remains robust. At the margin, buoyant non-U.S. economies are likely to provide a boost to the U.S. economic growth. As the chart below shows, a comparison of the S&P 500 and non-U.S. markets show that while the SPX led the rally in weeks after the November election, non-U.S. markets have caught up and have been outperforming since early March. Even if a case could be made that the U.S. equities were rallying because of the anticipation of Trump tax cuts and deregulation, the same argument would not hold for non-U.S. stocks. The Trump trade is dead, but the global reflation trade lives on. Exhibit 5: The Trump Trade Is Dead, But the Global Reflation Trade Lives On Source: Stockcharts Cam Hui, CFA | (604) 724-8404 Page 5 June 13, 2017 Quantitative & Strategy Callum Thomas of Topdown Charts pointed out that indicators of global trade are rising, which is bullish for growth. Exhibit 6: Global Trade Is Strong Source: FactSet Tom Orlik, Chief Asian Economist at Bloomberg, came to a similar conclusion when he analyzed the latest Chinese trade statistics. Exhibit 7: Chinese Trade Growth Is Strong Source: Bloomberg Cam Hui, CFA | (604) 724-8404 Page 6 June 13, 2017 Quantitative & Strategy Across the Atlantic, eurozone growth was revised to the highest rate in two years. Exhibit 8: Eurozone Growth Rebounding Source: HIS Markit, Eurostat In short, while U.S. economic conditions may appear to be a bit soft, the global outlook is strong. In the absence of strong evidence to the contrary, the Fed should continue on its path of monetary policy normalization, which translates into three rate hikes this year and the initiation of balance sheet reduction in either late 2017 or early 2018. Here Comes the New Fed Governors So far, what we have described is the most likely outlook of the current Fed, which is likely to change soon. The New York Times reported that Trump is about to nominate Randy Quarles, a former Treasury official in the George W. Bush administration, and Marvin Goodfriend, former Richmond Fed economist and academic, to the Federal Reserve Board of Governors. Bloomberg also reported that Robert Jones, the chairman of a community bank, is being considered for a seat on the Fed Board. If these nominations do proceed, it begs the question of who the next Fed Chair might be. Any new Fed Chair would have to be on the Board of Governors, and there are three vacancies with three potential nominees. We can either interpret the identification of these potential candidates as Trump's intention to keep Janet Yellen as Fed Chair, or her replacement will come from one of the three new governors. Consider the functions of the three candidates as clues to Yellen's possible replacement. Jones would fill the seat reserved for small bank representation. Quarles' mandate is likely to be deregulation. By process of elimination, the most likely outside candidate to replace Janet Yellen is Marvin Goodfriend. Cam Hui, CFA | (604) 724-8404 Page 7 June 13, 2017 Quantitative & Strategy Who Is Marvin Goodfriend? The next question for investors is, "Who is Marvin Goodfriend?" Gavyn Davies recently wrote an endorsement of Goodfriend in the FT, "Marvin Goodfriend would be good for the Fed". Here is a brief summary: Goodfriend's conservative pedigree goes all the back to Reagan's Council of Economic Advisors. He is a typical member of his generation...in having a very profound distaste for inflationary monetary policies. Goodfriend believes in a formal inflation target, which he thinks should be approved by Congress, rather than being set entirely within the Fed. On the Taylor Rule, Professor Goodfriend has recently argued that the FOMC should explicitly compare its policy actions with the recommendations from such a rule, because this would reduce the tendency to wait too long before tightening policy. Goodfriend believes that interest rates are a much more effective instrument for stabilizing the economy than quantitative easing. Goodfriend has frequently argued forcibly against allowing an “independent” central bank to buy private sector securities such as mortgage-backed bonds, which he deems to be “credit policy”. Goodfriend has always been worried that “independent” central banks will develop a chronic tendency to tighten monetary policy too late in the expansion phase of the cycle. In other words, Goodfriend has the academic credentials and ticks off all the boxes to be a good Republican Fed Chair in an old-fashioned monetarist mold. We believe the most important difference between Goodfriend and the current Fed is Goodfriend seems to favour price level targeting, instead of inflation targeting.